What the CNB can Learn from Israel

By: Sam Vaknin, Ph.D.

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Written: September, 1998

The (Czech National Bank) CNB is one of the most autonomous in the world. It is also heavily influenced by current economic fashions. These fashions were propagated and disseminated throughout the world by the IMF in the last two decades with disastrous consequences. The IMF (and most central banks) are obsessed with the attainment of low inflation and macroeconomic stability. These goals are commendable - but when pursued too zealously they are deflationary, recessionary and contractionary. Naturally, inflation tends to be lower when the economy contracts. Perfect macroeconomic stability is achieved only in a graveyard. Coupled with free capital flows this recipe is downright dangerous.

The sequence is simple and inevitable - but, luckily, fully reversible. Governments are inclined (justly) to increase deficit spending to reflate the economy in times of recession. This is a counter-cyclical Kenseyan reflex. Money is injected to a languishing economy through the budget. The central bank tries to counterbalance the "deficit poison" by applying an antidote of high interest rates. Money supply is reduced sharply. High interest rates attract speculative "hot" money. Where free capital flows are permitted - foreign speculative funds will drive down the exchange rates of the domestic currency versus foreign currencies. Where capital flows are more restricted, domestic corporations will borrow in foreign exchange and invest in high yielding domestic currency deposits and bonds.

Both these things happen in the Czech Republic. Foreign currency reserves ballooned by 13% in the 12 months to September. Speculators (foreign and domestic alike) borrow in USD or DM and then convert the proceeds to Czech korunas. They enjoy the difference between the high rates on koruna deposits offered courtesy the CNB and the much lower interest they pay to their lenders. An added bonus is the strengthening of the Czech koruna versus other currencies which provided the speculators with capital gains as well. In a way, the CNB subsidizes and awards speculation. It did reduce interest rates by 2.5 percent in the last 4 months - but this is by far too little and much too late. Actually, as opposed to any known market logic, the koruna APPRECIATED against the DM and the USD in the wake of the latest, very unexpected, rate cut. Now that there is no Damocles sword (further imminent rate cuts) hovering above the speculators - it is even safer to engage in koruna games.

The proceeds of these massive conversions to the Czech koruna were invested mostly in government bonds. Some of it even filtered to the corporate bonds market. The idea is to enjoy a "triple whammy". First to earn the aforementioned difference between interest paid and interest received. Second, to enjoy the appreciation in the Czech koruna versus foreign currencies (which means that less korunas are needed to repay credit denominated in foreign exchange). Third, to enjoy the appreciation in the value of bonds in an environment of guaranteed cuts in interest rates. The very sluggishness of the CNB is a boon to speculators.

The real economy does not benefit from such an application of monetary medicine. Banks do not lend more following rate cuts because they are choking on bad debts. Borrowers postpone borrowing in anticipation of further rate cuts. Consumers don't spend because real interest rates are still outlandish. With a core net inflation of c. 5 percent and a repo interest rate of 12.5 percent, there is very little incentive to consume. Consumer credit has dried up, the savings rate is going up, the economy is languishing in official recession.

A currency bubble ensued. When it bursts - the whole economy will suffer. Witness the Asian Tigers - now reduced to paper tigers.

The overvalued currency damages the economy twice: once while it is overvalued and once when it is sharply devalued by market forces. While overvalued, it encourages imports and discourages exports. It distorts the allocation of economic resources - investors prefer to speculate rather than to invest in industry or services. The high interest rates required to maintain the unrealistic exchange rate stifle all economic activity. True, inflation is held at bay by an influx of cheap imports and by a reduction in the money supply. Simply: less money available to buy goods and services translates to lower prices. But this is artificial. the "missing" inflation is merely pent up.

Ultimately, the economy is discernibly damaged by this policy and people begin to get rid of the domestic currency. As inflation is subdued, interest rates have to come down - making the currency much less attractive. A rapid devaluation followed by inflation are the results. The whole economy is destabilized.

For years, the central bank of Israel, headed by the venerable economist, Prof. Jacob Frenkel, has prescribed these medicines to the ailing Israeli economy. Interest rates were kept abnormally high. The New Israeli Shekel appreciated by 50% in real terms in four years. Inflation went down from an average annual level of 18% to 4% currently. But the price was dear: a stubborn unemployment rate of c. 10%, a financial bubble which burst with tremendous economic impact, the influx of c.10 billion USD in speculative "hot" money (including money from questionable sources), a current account deficit of 6-7% of GDP (discounting unilateral transfer from the USA and the World Jewry) and, in the last two years, a stagnant economy . Finally, the currency gave in: it depreciated from 3.72 to 4.32 to the USD in a matter of two weeks. Inflation will soon follow. So what was it all for?

This is the question that resounds now throughout the world. Fiscal austerity and monetary restraint are not an ideology to be applied dogmatically and intransigently. They are weapons in an arsenal. They should not be relied on exclusively. Otherwise, the battle is lost.

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